JPMorgan's $20 million fixed-to-floating CMS curve, S&P 500-linked notes appealed for yield

By Emma Trincal

New York, April 24 - JPMorgan Chase & Co.'s $20 million of fixed-to-floating-rate leveraged CMS curve and S&P 500 index-linked notes due April 30, 2028 attracted investors for the high fixed coupon paid during the first two years, sources said.

The notes were the largest offering to price last week amid relatively slow activity.

The coupon was 7% for the first two years, according to a 424B2 filing with the Securities and Exchange Commission.

After that, it was four times the spread of the 30-year Constant Maturity Swap rate over the five-year CMS rate, up to a maximum annualized rate of 7%, for each day that the index closed at or above the 75% barrier level. Interest was payable quarterly and could not be less than zero.

The payout at maturity was par.

Generating yield

"People are looking for high yields. It's almost as if the headline rate was really what people are looking at in those products. They're probably attracted to the 7% for the first two years before even looking into the underlying itself," a sellsider said.

"It's understandable. A 7% coupon for the first two years, that's already 14%, or just about 1% per year. That's good in this environment. If you get additional coupon, then that's even better.

"Now of course if it moves against you, you potentially could have 15 years without any return except for the first two years. That's the trade-off."

After the first two years, the interest rate is variable. Investors' return depends on the CMS spread and the fluctuations of the S&P 500 for the calculation of the accrual days, he noted.

Investors will get paid only if the 30-year minus five-year CMS spread is positive and for as often as the S&P 500 closes above the barrier level, according to the prospectus. If the spread is negative, there is no coupon payment.

"Investors are not necessarily very familiar with CMS spreads," the sellsider said.

"But they can still read the prospectus and try to figure out what is the likelihood of getting as much coupon as possible.

"If you take a look at the historical data, you can try and get your arms around it. You look at the 30-year minus five-year CMS and you try to get a sense of how often you would've gotten the coupon. My guess is that it must have performed well."

Historical performance

In the historical information section, the prospectus displayed a chart showing a positive spread almost always since January 1998, except for a very short period in January 2000. During the reference period, which went from Jan. 1, 1998 to April 19, 2013, the CMS spread was negative only for 32 days, according to the prospectus, which warned as a waiver that past performance is not indicative of future performance.

Investors are also subject to fluctuations of the S&P 500 index, a less predictable factor, for the calculation of the accrual days.

During a historical period from July 14, 1998 through April 19, 2013, the index closed below 75% of its initial level 39% of the time, according to a table displayed in the prospectus.

While the variable rate is capped at 7%, investors enjoy the four-time leverage. As a result, they only need the CMS spread to be 1.75% in order to maximize their coupon rate, sources said.

"The search for yield is what drives investors to buy those longer-dated products. People go for either very short-term reverse convertibles or those long-term notes with a high initial coupon and possibly decent return potential," the sellsider said.

A market participant agreed that the product is appealing to investors seeking yield.

"But I'm surprised that it's not callable. It's a very long-term product. Usually on those 15-year notes, it's often assumed that it's callable," he said.

"It's probably retail issuance. Sometimes some treasury departments at certain banks would create some rate structures for hedging purposes."

Lesser-known underlying

"It's really the kind of structure that gives you better income than what's available in the market. People like it for that and also for the principal protection," he said.

One of the difficulties issuers may have when selling those products is the hybrid underlying, which comprises an equity benchmark determining how many days the coupon gets paid and a type of rate investors may not be accustomed to, he explained.

"It's probably hard to explain to investors because people are not familiar with CMS spreads. These are broker-sold deals. Brokers have some trust established with their clients. Hopefully, they take the time to explain how the structure works," the market participant said.

The 30-year CMS rate and the five-year CMS rate are the rates for U.S. dollar swaps with a 30-year maturity and a five-year maturity, respectively.

An interest rate swap rate indicates the fixed rate of interest that a counterparty in the swaps market would have to pay for a given maturity in order to receive a floating rate equal to Libor for that same maturity.

"Regardless of how the concept of CMS spread is understood, at the end of the day, these deals get sold for the high fixed rate. Getting 7% for two consecutive years in this environment is very appealing," the market participant said.

The notes (Cusip: 48126DS59) priced April 19.

J.P. Morgan Securities LLC was the agent. Distribution was through Morgan Stanley Smith Barney LLC.

The fee was 3.5%.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.